Note No. 179 April 1999 Public Disclosure Authorized Regulation in New Natural Gas Markets— The Northern Ireland Experience Peter Lehmann So far gas market liberalization has generally occurred in mature markets—particularly where much of the pipeline system has already been laid, as in Argentina, Britain, and the United States. In these cases a competitive structure is appropriate. In new markets, however, it may be difficult to introduce a competitive regime from the outset, and a different approach and form of regulation, such as a period of exclusive licenses, may be needed.1 In 1997 the Northern Ireland Public Disclosure Authorized authorities awarded Phoenix Natural Gas an exclusive license for a limited period to develop a new gas market from scratch in the greater Belfast area. This Note explains the rationale for a period of exclusivity and describes Northern Ireland’s approach to gas market regulation. The Northern Ireland authorities had been eager The economics of supplying gas to areas outside to develop a natural gas market, both for envi- Belfast are difficult, though better opportunities ronmental reasons and to make the province may develop. Indeed, in a new gas industry it more attractive to foreign investors. Their effort can be argued that the initial development was triggered by the conversion to natural gas of license should be granted only for part of a a power plant in Northern Ireland, with com- region or country. In that case it may be best to missioning in 1996. The plant was owned by develop the network as a series of regional fran- British Gas (now BG), and the gas is transported chises. That way, two or more licensees will be Public Disclosure Authorized from Britain by a subsea pipeline. This pipeline well placed to compete in each other’s areas provided an opportunity to deliver natural gas to once the industry matures. homes and industry. Monopoly in transportation To take up this opportunity, a license for natural gas for the greater Belfast area was granted to The authorities accepted British Gas/Phoenix’s Phoenix Natural Gas in a tender limited to only argument that a long (twenty-year) transportation one other candidate. Phoenix was originally a 100 monopoly period was needed to attract an percent subsidiary of BG, though Keyspan Energy investor into the market. The necessary invest- now has a 24.5 percent shareholding. Phoenix ments appeared to British Gas/Phoenix to be was granted a combined license for transport and fairly marginal. Major marketing risks stemmed supply, but different approaches were used for from having to displace coal, liquefied petroleum the two activities. An exclusive transport license gas, and oil in the residential market and from the lasts twenty years, but competition in supply will dependence of Phoenix on the decisions of a be allowed after only two to eight years. single body, the Northern Ireland Housing Public Disclosure Authorized Executive, the public housing authority that owns Northern Ireland contains 600,000 households, more than a quarter of the houses in greater with just over 250,000 in the greater Belfast area. Belfast. There were also substantial technical and The World Bank Group b Finance, Private Sector, and Infrastructure Network Regulation in New Natural Gas Markets—The Northern Ireland Experience financial risks. The authorities decided that all If Phoenix does not meet its obligations, it will these risks would be compounded if multiple lose its exclusive license in the districts where it infrastructure licenses were granted. fails. Thus other companies could then be granted transportation licenses. The authorities also agreed with British Gas/ Phoenix that a single license would have other Transportation charges advantages. A single developer is more likely to develop an optimal, well-designed “backbone” From the outset Phoenix has maintained separate network (avoiding, for example, multiple pipes charges for the use of the transport network by and wires running down the same street). And a gas suppliers and for the supply of gas to final single developer is easier to deal with in terms customers. Until competition is introduced, the of granting approvals, planning traffic, making transport charge will simply be a transfer price contingency plans, and providing local authority between Phoenix’s distribution and supply support services. businesses. Development obligations Both Phoenix and the authorities recognized that the price to final customers would have to be One of the authorities’ primary goals was to kept low for many years to persuade customers secure the construction of an extensive natural to switch to gas and that the overall costs of sup- gas pipeline system in Belfast. Thus investment plying gas would be dominated by the transport obligations were a key part of the license. Several charges. Thus the debate over pricing focused on challenges arise when an investment program is the transport charges; the supply prices were less expected of an exclusive licensee: how to ensure contentious. that the investment takes place, what sanctions to put in place if it does not, and how to deal Standard approaches to setting transport with unforeseen circumstances. charges are not appropriate for a new industry. The regulatory asset base starts from zero, The license requires Phoenix to complete its net- changes rapidly, and is unpredictable. If charges work in twelve years and to perform the work in are based on a return on assets, they would be each of Belfast’s twelve districts in a specific order, exceptionally high at the outset (because of low within a specified timeframe. Moreover, a pipeline utilization) and would change sharply from year must run within 50 meters of 90 percent of the to year. Thus it was decided to set transport homes in each district. This was a much more charges at a level that is expected to provide an detailed blueprint than Phoenix would have liked. 8.5 percent real pretax return on cash flows over Phoenix argued that it already had major sunk twenty years, with calculations based on fore- investments—in medium- and high-pressure cast capital and operating costs, sales levels, and pipelines—and so had the necessary commercial mix of sales. Phoenix considered this return incentives to connect up the maximum load. The rather low given the risks involved in the detailed blueprint created a risk that Phoenix will project. But there was some upside from the fail to meet its obligations. Two safeguards for prospect of additional transport revenue after Phoenix reduce but do not eliminate the risk: the initial twenty-year license period. The big b The regulator can agree to changes in the question mark was the enormous uncertainty order and dates of pipeline construction if about all the forecasts. To address this uncer- there are good reasons for doing so. tainty, it was agreed that there would be a b Phoenix does not have to lay pipes past hous- reforecast every five years, with one possible ing that the Northern Ireland Housing Executive additional forecast in the initial five-year period. had not converted to, and does not intend to Under these reforecasts the previous five years convert to, natural gas. will be “water under the bridge”—that is, Phoenix will retain any gains and bear any The scope for competition may be limited given losses if developments differ from what was the small or nonexistent margins between trans- forecast. Thus there are incentives for efficient port and supply charges for many years. Still, and rapid market development. However, prices Phoenix wanted an initial exclusivity period. The for the remaining period of the license would be company was concerned that potential competi- adjusted in light of changes in the forecasts so tors would protest and that the authorities would that the net present value over the remaining take action if competition did not develop when period, given the new forecasts, would be the it was permitted on paper. In the end the exclu- same as in the original net present value sivity periods agreed on were quite short—partly calculations. because the rest of the United Kingdom has com- petitive gas markets. One of the most controversial issues in the nego- tiations over transport charges was how to deal Prices to final customers with changes in the distribution of gas sales among market segments and with the effects of A key challenge for the new gas industry is to such changes on costs and average prices. In win customers who are using competing fuels. addressing these matters the authorities wanted The gas industry sometimes argues that it needs to prevent excessive profits for Phoenix, but also neither regulation nor gas-to-gas competition to provide incentives for rapid development of because there is strong competition between the network and market. fuels. In a mature market with many gas cus- tomers, interfuel competition may need to be Competition in supply supplemented, especially in the residential mar- ket. But where a gas industry is being estab- In a mature utility industry it is generally desir- lished, the industry’s argument is valid. able to separate the transport business and the supply business, as there is different scope for Thus in Northern Ireland there is no regulation competition and different competitors in the two of gas prices to consumers, other than rules bar- sectors. In a developing industry, however, too ring discrimination, for the first five years of the strict a separation is undesirable. For example, license. After that the regulator can introduce a the transport arm and the supply arm should price formula if he decides that customers’ inter- plan an integrated rollout of the network to avoid ests are not adequately protected by competition major cost inefficiencies.